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Behavioral Finance

Experiencing Short-Term Losses Is a Part of Long-Term Gains

Far from unusual, downturns are an integral part of even the highest returning investments.

Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment  |  Published: February 9, 2016

Investors often worry and react with panic in response to market drops, even if they are invested properly for their long-term goals.

Interim losses are to be expected even during the best investment periods.

Reacting to market declines, more often than not, means underperforming.

Customers are often surprised when I say that I expect losses in the Betterment portfolio.

No, I’m not a masochist nor pessimist. Instead, this perspective comes from having studied and experienced financial markets for years.

I’ve learned that losses are usually common, fleeting, and benign—as long as you know you’re invested appropriately and are expecting, rather than reacting, to them.

Being invested appropriately means taking our recommended risk level for your goal and time horizon. Betterment’s advice incorporates a balanced risk and return over the number of years for which you’re investing, but it’s up to you stay the course.

Taking on more risk than recommended means you’re risking a significant decline, which can cause you to miss your goal or react emotionally.

Conversely, taking on too little risk means you are leaving potentially higher returns on the table over a period where you could otherwise afford to take the risk.

As demonstrated below, it’s nearly impossible to achieve even the most impressive level of returns without going through some pretty significant declines.

A Top-Return Decade Shows Almost Two Drops Per Year

To illustrate this point, we’re showing data on the S&P 500 index, not because it’s a good investment comparison benchmark, but because it has a long history of measureable data going back to 1950.

We looked at every possible decade, starting on every day of every year, to find the best return periods.

For example, the highest returning decade started on Sept. 25, 1990, ending Sept. 25, 2000. Over this period, the S&P 500 returned an amazing 487%, or 17.2% on an average annual basis.

Best Possible Period for S&P 500 Return

Best possible return

Data Source: S&P 500 index data from Yahoo Finance

However, what the graph masks are the dramatic losses in value that an investor had to bear. Let’s take a look at the declines an investor would have lived through in order to achieve those remarkable returns:

Drawdowns Within Best Possible Period

Best possible drawdowns

Data Source: S&P 500 index data from Yahoo Finance

Maximum Drawdown within Each Year

biggest annual loss

Data Source: S&P 500 index data from Yahoo Finance

This pattern is found in only average-performing market outcomes as well.

In fact, all of the top 10% decades of returns—or those with cumulative returns over rolling 10-year periods that are beyond the 90% quantile of the distribution—experienced substantial declines. This accounts for 1,404 portfolios in total. As reported in the table below, 100% of these portfolios experienced drawdowns of up to -15%.

Chance of Significant Drawdown for Best Time Periods

Loss Percent of Periods
5% 100%
10% 100%
15% 100%
20% 39%
25% 35%

If we look at all decades, in an average decade of returns, the chance of experiencing a drawdown of at least -15% is 100%, and 79% (about four out of five years) for experiencing a drawdown of 25% or more. Significant short-term losses are common, even in what are pretty average investing environments.

Chance of Significant Drawdown for All Time Periods

Loss Percent of Periods
5% 100%
10% 100%
15% 100%
20% 88%
25% 79%

Actual Betterment Customer Returns

The graph below depicts the actual time-weighted returns of all live Betterment customer goals for individuals saving at least $100 a month, based on for how long the goal has been active.

Newer goals (those with less than two years investing) on average have moderate losses. However, on average, those goals older than two years have significant positive returns.

All Goal Returns By Tenure

betterment returns by tenure

Data Source: Betterment. All live goals saving at least $100 per month as of Jan. 15, 2016. Time-weighted returns net of fees and dividends reinvested. “Active investors” make more than one allocation change every two years. “Set-it-and-forget-it” investors make less than one allocation change every two years.

You may be wondering why some goals have below-average returns even in the later years.
There are usually three main causes of this:

  1. At some point, the account was saving less than $100 a month, and thus had a $3 per month fee (using Betterment’s previous pricing structure1).
  2. The individual has frequently changed his allocation.
  3. The goal was always a very low-stock allocation goal.

As we’ve shown previously, changing allocations frequently is the one of the the most likely culprits for lower returns. Reacting to market drops does not help long-term investment goals.

Expect Volatility in Sound Investments

If significant and worrisome market activity is such a frequent part of investing, what’s an investor to do?

The first step is to get used to the idea of watching your portfolio value roller coaster to achieve long-term goals.

Preempt downturns by remembering that these drops are usually short-term risks, and bearing short-term risks is what makes long-term portfolios experience higher expected returns.

Your “job” in order to earn those potentially high returns is to soldier on through tough times.

Scratching an itch usually won’t prevent it from recurring, and the same goes for reacting to short-term losses in your portfolio. In this case, the recommended best practice is to let your understanding of volatility trump emotional or impulsive reactions which could lead to mistakes.

If you react to losses in your portfolio, you are engaging in market timing, and attempting to chase performance. This involves taking money from investments that have performed poorly, and putting it into asset classes that have performed well.

As we’ve noted, short-term returns are not a reliable gauge for long-term performance, and performance chasing generally leads to investors under-performing.

Based on the performance of the S&P 500, as well as Betterment’s average cumulative returns among long-term investors, any investment strategy will include short-term losses.

Instead of reacting with panic at any sign of market volatility, preempt anxiety and fear with the knowledge that you are invested appropriately for your goals.

1We’ve updated our pricing structure since this article was published. Learn more at betterment.com/pricing.

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